Purchasing Power Parity (PPP) theory

The Purchasing Power Parity (PPP) theory is a concept in economics that compares the prices of
comparable products and services to determine the comparative worth of currencies in various
nations. It is founded on the premise that, in the longer run, currency exchange rates among
currencies ought to fluctuate to balance each currency's buying power.
According to the PPP theory, if two nations possess an identical bundle of commodities, the rate
of exchange among the currencies of both nations ought to fluctuate such as to ensure the
commodity's cost equals one another in the two nations. In simpler terms, the exchange rate
ought to indicate every nation's relative pricing for products and services.
In line with the PPP theory, if the currency of one nation is lower than another's, the currency
value of those nations with less expensive goods should be predicted to rise as time passes. The
increase in value is required to reconcile the buying power of each of the two currencies,
resulting in it being costlier to purchase items in the lower-cost country.
The PPP theory has a number of consequences and applications. It is frequently used to calculate
the "fair" worth of currencies, making it useful for global trade, investment choices, and
economic research. PPP may also be utilized to assess different countries' standards of life and
costs of living. PPP allows a more realistic evaluation of income levels and economic wellbeing
amongst nations by compensating for the relative pricing of products.
It is crucial to emphasize, however, that the concept of PPP has restrictions and obstacles. It
implies that markets are efficient, expenses for transportation are minimal, and trade obstacles
are non-existent. In actuality, these presumptions might not remain true, resulting in short-term
departures from PPP. Furthermore, PPP may fail to correct for variations in quality, choices, and
non-tradable commodities, which might skew comparisons.
As a whole, purchasing Power Parity theory presents an approach for analyzing the link across
exchange rates and relative prices among nations, with the goal of eventually equalizing the
buying power of various currencies.
The absolute version of Purchasing Power Parity (PPP) theory is an economic concept that
asserts that an exchange rate between two currencies is required at a level where each currency's
buying power is equal. In a nutshell, the absolute PPP theory proposes that whenever measured
in a single currency, the cost of a particular portfolio of goods and services must be identical in
various nations.
As to the absolute PPP theory, if the rates of goods and services rise in a single nation in
comparison with another, the local currency of the higher-priced state should decline relative to
the currency of the lower-priced country. This depreciation is required to restore balance and
equalize the buying power of the two currencies.
Most of the times inflation of Sri Lanka is higher than United Kingdom (UK). Accordingly, Sri
Lanka imports more from United Kingdom due to lower price levels than in Sri Lanka. Further
Sri Lankan exports will be reduced when GBP appreciating. On the other hand, prices of UK
goods in UK is lower than Sri Lankan goods. Therefore, customers in UK demands more UK
goods.
In a nutshell, Sri Lankan demand is higher for UK imports. Therefore, there will be a more
demand for GBP. As a result of higher demand for GBP, it will be appreciated compared to
LKR. On the other hand, Sri Lanka demand is lower for their local products and services due to
highly expensive with the high inflation and UK demand is again lower for Sri Lankan goods
and services due to higher inflation. Then there is a lower demand for LKR from UK. Therefore,
LKR will be depreciated compared to GBP.
The initial scatterplot displays the association between Sri Lanka's monthly exchange rate and
the variation in inflation rates for the country and the United Kingdom (UK). The scatter plot
reveals a distinct separation of data points and trend lines from the PPP line. In accordance with
Baumol and Blinder (2015), a graphical representation of the link among exchange rates and
variation in inflation rates illustrates if observations deviate significantly within the PPP model's
trend line.
There is a weak negative relationship between the difference of inflations rates and percentage
change in exchange rates. Accordingly, these points are highly deviate, PPP doesn’t hold which
indicates that when assessing the buying power of a currency in numerous countries, its relative
worth keeps steady throughout time. To put it another way, if two nations possess the same
degree of inflation, the exchange rate among their currencies must stay steady in order to retain
equal buying power. As PPP is in place, the price of a particular bundle of goods and services in
various nations should be identical when assessed in a common currency.
PPP indicates that no major departures of the theoretical connection between exchange rates and
relative price levels exist. If the exchange rate differs from the PPP value, it indicates that one
currency is overvalued or undervalued relative to the other.
Yet it is crucial to emphasize that, in practice, PPP is frequently not maintained in the short term
owing to a variety of issues such as market inefficiencies, transaction costs, trade obstacles, and
variations in non-tradable commodities and services. Deviations from PPP can emerge and
persist over time, causing exchange rate volatility.

References
https://www.investopedia.com/updates/purchasing-power-parity-ppp/
https://www.ig.com/en/trading-strategies/what-is-purchasing-power-parity--ppp---191106
https://www.imf.org/en/Publications/fandd/issues/Series/Back-to-Basics/Purchasing-Power-
ParityPPP#:~:text=The%20other%20approach%20uses%20the,and%20services%20in%20each
%20country.